Gold and International Trade Settlement (Part 2)

(A New Gold Supra-Theory – Post 2.)

Please Note: As a result of feedback on this post it became clear to me that I had to separate the explanation of Hume's mechanism from the discussion of international trade settlement. So I have created a post in two parts called "The ECB Targets 1752" that looks at the mechanism in the Eurozone.

I'm going to rework this post and discuss trade between currency zones here in order to keep to a 3 part limit. The original text will be archived and accessible. Warren James is helping me to put this together. My apologies if my learning curve is annoying anyone.

I'm determined that the build-out of this theory isn't going to become multi-layered. I don't want people to have to drill down through 5 layers of old posts to understand each component. Likewise if I commit to a maximum of 3 parts (as I have with this topic) I don't want it to become 4, 5 or 6 in the future. If updates are required then the existing parts may become longer posts but they will be reposted as "updates" to replace the original. The original text will continue to be accessible.

Cheers!

The challenge for the New Gold Supra-Theory is to predict how a new gold-based international monetary and financial system (IMFS) will operate. In part one I mentioned the ‘price-specie-flow mechanism’ originated by David Hume (1711-1776). An insight into international free trade that was further developed by classical economists such as David Ricardo. This mechanism may have influenced the design of the ECB Eurosystem’s Target 2 system.

The source I am drawing on for this post is a very dense, scholarly book published in 1937 called “Studies in the Theory of International Trade”. The writer was a Professor of Economics at the University of Chicago named Jacob Viner (Here’s a link to his bio.) It discusses the work of the classical economists on international free trade theory in great detail as well as the many debates they were involved in.

If anyone expects gold to correct international trade imbalances on its own via some mechanism like this the news isn’t good unless gold becomes a circulating currency again. However, if (as I do) you expect gold to tightly discipline currency issuers and to discover currency prices through international arbitrage then it’s no big deal. Currency exchange rates will get the job done that a flow of specie would have accomplished in the distant past. The description of this mechanism is usually presented (inadequately) like this short Wikipedia entry.

As I said in Part 1 this mechanism doesn’t require a gold standard to operate. It can and did operate under a mixed currency system. Classical economists were also able to observe the effect on this mechanism during periods when gold exchange was suspended by the Bank of England. Jacob Viner discusses a number of other factors, aside from prices, that influenced the operation of this mechanism including real costs, relative demand, velocities (that’s plural) and so on. I’m only referring to prices here for the sake of brevity. Here’s my summary of the features and limitations of this mechanism:

1. It requires the trading partners to be in the same currency "zone" i.e. using the same money (e.g. gold, silver, Pounds etc) So the Eurozone is readymade to benefit from this mechanism if the Euro is managed well. We should be able to see its influence at work in the numbers emerging from the Eurozone over time as it tends to equalize the prices of internationally traded goods to reflect one price plus transport and distribution costs and relative demand.

2. This mechanism worked both internationally and between regions within countries through deflation and inflation of the currency supply. This in turn influences prices and other factors that encouraged a constant flow of money. As prices etc adjust the flow responds until the amount of money in each country or region returns to its starting position. I imagine tidal forces when I try to picture this mechanism in operation.

3. This mechanism increased the diversity and volume of goods available in each region/country. There is an extract from Viner quoting Ricardo on this topic below.

4. It apparently exercised no influence over the amount of bank-created money. This was a regulatory and policy issue that was the subject of a long running controversy between the “currency school” and the “banking school”. Viner also reviews these debates in great detail.

5. The classical economists and Jacob Viner dismiss the possibility of any index being able to simulate the effect of this mechanism. This mechanism works but it’s impossible to prove it with statistics. In an interventionist world like ours today if something can’t be indexed or measured in some way it doesn’t matter or doesn’t exist for policy makers. That’s a huge impediment for the supporters of free trade even though the logic appears to be impeccable.

P. 342 Jacob Viner (my emphasis):

Free trade, therefore, always makes more commodities available, and, unless it results in an impairment of the distribution of real income substantial enough to offset the increase in quantity of goods available, free trade always operates, therefore, to increase the national real income. That the available gain is ordinarily substantial there is abundant reason to believe, but the extent of the gain cannot in practice be measured in any concrete way.

(From Page 339-40 of “Studies in the Theory of International Trade”)

... Ricardo went on to say that “it will very powerfully contribute to increase the mass of commodities, and therefore, the sum of enjoyments.” What was intended by Ricardo as the main proposition was, at least for our present purposes, of no importance. The incidental comment, on the other hand, was of great importance. It suggests two income tests of the existence, and perhaps also two income measures of the extent, of gain from trade, namely, an increase in the “mass of commodities” and an increase in the “sum of enjoyments.”

Ricardo did not expand these suggestions, but in his Notes on Malthus he repeated them: if two regions engage in trade with each other “the advantage ... to both places is not [that] they have any increase of value, but with the same amount of value they are both able to consume and enjoy an increased quantity of commodities,” adding, however, that “if they should have no inclination to indulge themselves in the purchase of an additional quantity, they will have an increased means of making savings from their expenditure.”

I would like to leave you with a question to ponder. If all currencies are fully convertible (freely exchangeable [1] with each other) and there is no intervention inhibiting the flow (such as capital controls) then all of the world's currencies would be like one single fungible money supply. Of course there is constant intervention in many currencies. So if you wanted to promote international free trade it would be helpful if you could create an international reserve currency that no one could mess with, would it not? 

 

In the third and final part of this series I’ll present an issue that I think has brought those of us who anticipate a new gold-based IMFS to an impasse -  a stalemate. I think it needs to be addressed so we can move on.

[1] Another hat tip to DP. I added 'with each other' in order to try to make it clearer that this is purely an exchange of currencies and not a reference to a gold exchange standard.